When the global financial system was thrown into crisis, many policymakers were shocked to discover a gaping hole in their policy toolkit.

They have since made significant progress in developing macroprudential policy measures aimed at containing system-wide risks in the financial sector. Yet progress has been uneven. Greater efforts are needed to transform this policy patchwork into an effective crisis-prevention toolkit.

Given the enormous economic and human cost of the recent financial debacle, I strongly believe that we cannot afford to miss this opportunity for substantial reform. Modern macroeconomics evolved in response to the policy limitations that were painfully underscored by the Great Depression. Macroprudential policy could prove to be the next quantum leap. This is why the group of twenty leading economies (G-20) asked the IMF, Financial Stability Board (FSB), and Bank for International Settlements (BIS), to develop a coherent framework for this new policy.

It involves a wide range of systemic risk indicators—that is, indicators that gauge system-wide risks, rather than risks affecting individual institutions— focusing on such areas as the resilience of financial system to shocks, the availability of funding in financial markets, market participants’ interconnectedness, household indebtedness, and international capital flows. The list of policy tools includes, for example, countercyclical capital requirements, loan-to-value ratios that help prevent the out of control credit growth that led to recent housing bubbles, and systemic capital and liquidity surcharges reflecting institutions’ contribution to systemic risk.

Earlier this week, the IMF Executive Board discussed a new paper that sets out the IMF’s thinking on the main elements of the new policy. The paper—drawing also on a survey of 63 member countries—shows that further efforts are needed to develop new tools and broader, forward-looking measures of systemic risk. Moreover, a new policy framework—based on international best practices—will need to be firmly established. This would greatly reduce the risk of regulatory arbitrage by global financial firms seeking to exploit policy loopholes.

Systemic risks—both national and international—can no longer be addressed through the traditional mix of macroeconomic policies and “micro-prudential” measures aimed at individual financial institutions. By focusing on the health of the financial system as a whole, macroprudential policy can improve the authorities’ grasp of the intricate web of connections between financial institutions, financial markets, and the macro-economy.

The new tools would enhance policymakers’ ability to cope with two, interrelated drivers of systemic risk. They include (i) risks associated with swings in credit and liquidity cycles, driven by pro-cyclical forces such as leverage and herding behavior by financial institutions, non-financial firms, and households; and (ii) the concentration of risk in certain financial institutions and markets that are highly interconnected within, and across, national borders.

Developing a coherent policy framework is a really challenging task. National policymakers have been grappling with this, both at the conceptual level and in practical terms. The new IMF paper aims to clarify the concept of the macroprudential policy and its role in preserving financial stability. The IMF Executive Board, representing all member countries, broadly agreed with the proposed definition of macroprudential policy and its objectives, which is a milestone in developing the framework further. They have also accepted directions for further work, which would help the IMF facilitate the development and sharing of best practices throughout our member countries.

Yet, despite recent progress, many issues remain unresolved. For example, how strong is the evidence that macroprudential policies can, in fact, prevent or contain asset price bubbles? Which policy tool—or combination of tools—should be used? What about possible conflicts with other policy objectives in the monetary and fiscal areas? Which institutions would be best-placed to detect and contain future systemic risks?

The challenges facing policymakers are daunting. They need to:

Create a comprehensive analytical framework and a consistent set of policy tools, including through rigorous back-testing.

Establish macroprudential authorities with clear mandates to enhance their accountability and reduce the risk of political pressure. All institutional arrangements should reflect country-specific characteristics.

Assure addressing all systemic risks and manage potential policy conflicts through cooperation among national authorities.

Increase international cooperation to ensure the consistent application of national macro-prudential policies. The IMF stands ready to support such efforts through its surveillance mandate and financial sector expertise.

I look forward to the joint IMF-FSB-BIS progress report on the new macroprudential policy framework, to be discussed at the G-20 Summit in November 2011. We need further collective efforts to fill the policy black hole. It is our best chance of avoiding future crises.

9 Responses

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It seems reasonable that an international organization like the IMF (or the BIS) plays a role in macro-prudential surveillance. It has know how and information about global financial flows and linkages as well as a comprehensive view of balance of payment flows. A purely national surveillance misses essential factors of a globally connected financial markets and needs at least a close cooperation with other regulators.

Regulation, unlike surveillance, should remain the sole prerogative of national regulators.

There are simple indicators that are likely to be core to recognize an unsustainable development, namely credit growth and sustainability of public finances.

Behind this crisis lies a fundamental regulatory mistake: If you have credit information you can use it either to establish the interest rate or to establish the capital adequacy, but to use the same information for both purposes simultaneously, as Basel II does is to double-count for it.

That is what created the incentives for the banks to venture so excessively into what was officially perceived as having no risk, meaning what was triple-A rated and the “rich” developed sovereigns; and to lose interest in serving the small businesses and entrepreneurs and who although officially perceived as risky, have never caused a systemic bank crisis. And that is what also provided the strongest growth-hormones for the Too-Big-To-Fail banks.

And so this was not a financial or a business cycle it was a bad regulations cycle.

Now most or perhaps even all the policy tools currently developed, most direct components of Basel III, are trying to correct for the Basel II mistake, instead of correcting the Basel II mistake.

As a result, the regulatory system will turn even more complex and the what’s-happening, will be even harder to see and understand for all. All in all if it goes on this way we will have to face an extremely dangerous case of regulatory overmedication.

Sincerely, that those responsible for Basel II, or those who never saw its faults, can now in the same Basel Committee or in its clone the FSB be authorized to design Basel III, is truly mindboggling… and speaks badly about us other, and does not bode well for the future.

By the way, if there is any urgent easing to be done, that is relaxing the capital requirements for banks when lending to what is officially perceived as risky, like small businesses or entrepreneurs, a lending that has had nothing to do with the current crisis, a lending that has its own imbedded safeguards that hinders all excesses, precisely that of being perceived as risky, and a lending that has be so unwisely discriminated against.

Sadly, the IMF repeatedly demonstrates it does not understand the huge differences between a Monetarily Sovereign government and a government that is monetarily non-sovereign. So it proposes “solutions” that are inappropriate — even harmful.

Until they understand the very basis of modern economics, their discussions will be meaningless.